MLPs: ‘A Place in Every Portfolio’

July 01, 2013 at 08:00 PM

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Try finding a young asset class that financial advisors are more excited about than the high-yielding master limited partnership.

"My clients own two kinds of investments: those we're married to and those we date. We're married to energy MLPs," says Leonard Weiss, senior vice president of investments with the wealth-management group of Raymond James & Associates in Farmington Hills, Mich., in an interview. He's been investing in MLPs for more than a decade.

Indeed, at Morgan Stanley, MLPs have been one of the firm's top 10 investment ideas for the last few years, according to financial advisor Michael Bollinger, managing director, Morgan Stanley Private Wealth Management in Houston.

MLPs—many of which are companies that provide pipeline transport and storage for oil and natural gas—are conservative investments that offer consistent, stable income through distributions (i.e., dividends) that have the additional benefit of growth. While equities require earnings for improvement, MLPs are bolstered by increasing distributions. Moreover, MLPs offer tax advantages not available with common stock.

"What differentiates MLPs is their ability to continue to increase distributions over a longer, five-to-10-year time horizon. And that can overcome any correlation to equities, interest rates and commodities, because the fee-based pipelines—the piece of the marketplace that we focus on—are very consistent. It's similar to owning a private company that pays out cash flow," says Ethan Bellamy, managing director, Robert W. Baird Co., in Denver, in an interview.

There are two components to MLPs' total returns. "You get a return of capital, which makes the tax deferral possible [until you sell the MLP], and you also get distribution growth," explains Phil Blancato, CEO and chief investment officer of Ladenburg Thalmann Asset Management in New York, in an interview. "As more gas or oil is put through the pipeline, the greater distribution you'll get."

There are several options when investing in MLPs: buying shares of individual partnerships or turning to open-end mutual funds, closed-end funds, exchange-traded funds and exchange-traded notes. Investing in MLPs, many of which focus on the midstream section of the energy chain, is a significant way to participate in America's energy revolution and therefore the country's continuing effort to become energy independent, experts say.

Energy Revolution

"What is occurring in energy in the U.S. is our fourth revolution," Blancato notes. "First, there was the Agricultural Revolution, then the Industrial and Technological Revolutions. The fourth one focuses on the energy space. Investing with MLPs is a way to capture part of the revolution without having direct commodity-price exposure to oil and natural gas."

"It's a sunrise-sunset business model," shares Weiss, who adds that 45% of his clients own MLPs. "That is, natural gas, oil, petrochemicals are [always] moving through some pipeline, somewhere."

Now is a good time to invest in MLPs, analysts and advisors agree. In fact, "It's a perfect time. They offer liquid exposure to the energy boom that's happening. We're recommending that generally all our clients invest in them," says Ashley Lannquist, a senior analyst of investment research at New York-based Segal Rogerscasey, in an interview.

Advisors concur that MLPs are appropriate for most clients, not only those in the high-net-worth category, since the asset class is a great diversification tool. For smaller portfolios, ETFs or ETNs may be the best way to go, some suggest.

"The market tends to value MLPs higher than the same businesses that are in a corporate structure. Two utilities recently formed MLPs, and each one jumped 10%. They're the same assets but in a different structure," says Andy Pusateri, a senior utilities analyst with Edward Jones in St. Louis, in an interview.

MLPs are ideal for retirement planning, and indeed many advisors use them in this way to derive needed stable, consistent income. "For a taxable account in a retirement portfolio, most investors can have a 2%-5% allocation in MLPs to help enhance yield—especially now in this yield-starved environment," says Bollinger.

About 10 years ago, he rebalanced client portfolios by replacing portions of both equities and fixed income with MLPs. For many advisors, MLPs have replaced high-yield bonds, fixed-rate preferred stocks and Treasury bonds.

MLP Developments

Some new MLPs are those that occur in the downstream section of the energy chain. These non-traditional, or unconventional, MLPs are tied to cyclical or seasonal assets, such as refineries and nitrogen fertilizer.

There also are non-traditional MLPs launched recently that offer variable-rate distributions. They tend to have a more volatile income stream than traditional MLPs, which generally pay according to a set structure. "The variable-distribution MLP is a trend that has been solidly in place for the last couple of years and is likely to continue," says John Dowd, research analyst and portfolio manager at Boston-based Fidelity Investments, in an interview.

Variable-rate distributions, of course, may not meet some advisors' criteria for the income stability their clients seek. But, as Weiss points out, "They are certainly a better play than the traditional C Corp. And with an MLP, you get a huge tax benefit."

MLPs typically entail less volatility than the broader equity markets. And "they have a much better yield than equities," notes Daniel Kern, president-CIO of Advisor Partners RIA in Walnut Creek, Calif. (near San Francisco). "MLPs are a great way to get alternative income. It's a toll-road business model, where investing in pipelines and processing, the pipelines [and others] get paid a fee for usage. The MLPs have to distribute 90% of their income each year, so you get a claim on that revenue, a reasonably steady revenue base."

MLPs comprise about 5-10% of the firm's income portfolio, Kern notes. (He works primarily with investment advisors as a sub-advisor and also provides portfolio models to their high-net-worth clients).

One upstream MLP, Vanguard Resources, has moved to a monthly distribution. Vanguard's chief business is the acquisition, production and development of oil and natural gas properties. So far, it's the only MLP to have gone the monthly route, though others are considering it, Bellamy says: "It makes a lot of sense, because it will reduce volatility, which ultimately leads to better valuation."

Investors in Vanguard Resources do not receive cumulatively higher distributions, because they occur monthly. "They just receive a smaller amount more frequently," explains Lannquist.

Among the new, non-traditional MLPs are Hi-Crush Partners, which produces a specialized mineral used in hydraulic fracturing, and Lehigh Gas Partners and Susser Petroleum Partners, both wholesale fuel distributors. Blancato owns a few unconventional MLPs but notes, "You want to be selective, because they can have commodity sensitivity. However, this is one way to get commodity exposure, if that's what you're looking for."

Steady Streams

Most advisors treat MLPs as an alternative-income strategy. "It's an equity-yield hybrid, so it has equity-like characteristics and fixed-income characteristics in terms of yield," says Bollinger, whose team manages $400 million in discretionary separate MLP accounts.

"The MLP has a low correlation to equities in the long term and a low correlation to fixed income, although MLPs can be correlated with anything for a short time. What differentiates them is that over a longer time horizon they have the ability to continue increasing their distributions to the unitholders," he explains. "What you're really buying is that distribution, that cash flow; so over time, the MLP will decouple from the broader market."

MLPs are an emerging asset class with substantial room to grow. "The infrastructure spending on natural gas pipelines continues to go up every year in the range of $20 billion to $23 billion, so it's only going to get better," Blancato says. "Longer term, over the next five years, we expect a solid average rate of return of between 6% and 10% with very low correlation to the general market."

Choosing individual MLPs is a critical process, since these partnerships differ greatly from one another. "I research and study them to determine where they fall in the category that we'd like to use," says advisor Michael Flower, a partner with Financial Principles in Fairfield, N.J. (affiliated with Securities America). He then consults with his third-party money managers. "We'll get their opinions of various MLPs and choose five to eight of them to put into our clients' portfolios," Flower adds.

"You're paying an arm and a leg for a high- quality bond that might be giving you a 5% or 6% dividend. So where an MLP helps us is that, while it's a kind of stock, we feel comfortable we're not going to see downside fluctuation on the price as much as a good, consistent income with yields of usually 6%-8%. We're getting a bond-like dividend, but accepting a little more risk," he explains.

Most of Flower's clients fit into the mass-affluent category of investors, and their net worth starts at about $750,000; roughly 40% invest in MLPs. "They're very close to retirement or are in retirement and taking distributions, so a lot of them have MLPs that we're using for income," he notes. These large MLPs include Enterprise Products Partners and Energy Transfer Partners.

Since many clients—and even some financial advisors—are not very familiar with MLPs, Flower explains the asset class in simple terms. "It seems like clients don't really care about why you do the investment. They're more concerned about how these energy-related companies are in the middle of the energy chain, that you don't have to worry about the commodity price going up and down and affecting the company, and that they're there for transporting and storing the product," he says.

Strong Suitability

"We tell clients that a company is renting the pipeline and paying rent [to the MLP] as the product moves through it. Because of that, [MLPs] have good, consistent cash flows," shares Flower. "We stress that one advantage to an MLP is that they have to pay out a percentage of their revenues in the form of a distribution to investors."

MLPs' suitability for retirement portfolios cannot be overstated, experts say. "It's an ideal retirement asset. When you put it into a taxable account, that's where you get some significant tax benefit," says Greg Reid, managing director of Houston-based Salient Partners, as well as president and CEO of Salient's MLP business, in an interview.

In addition, MLPs are a great inflation protector. "There are very few investment opportunities where [dividends] rise because the cost of living rises. Fixed income provides fixed income," Weiss says.

Advisors who invest in exchange-traded products are looking to give their clients exposure to the energy boom without the risks of betting on individual MLPs. Kern, for instance, uses exchange-traded notes.

"We looked for a well-diversified ETN, and the one we chose has exposure to the 50-largest MLPs. We have access to petroleum, transport, natural gas pipelines and propane. We also wanted to buy an ETN with a counterparty risk we were comfortable with, so we chose the JP Morgan Alerian MLP Index ETN, which is up 22.9% year to date and yields about 4.4%," he says

Some advisors say they are paying more attention to coal MLPs. "During the last few months, as natural gas prices have trended higher, we've become a little more optimistic about coal," Bollinger says. To add a bit of diversification, the advisor has a small, 2%, allocation to a coal-royalty MLP.

"A few of the coal MLPs—Natural Resource Partners, for example—effectively own coal reserves that they lease out to experienced operators and then receive royalties," Bollinger adds. "Coal-royalty MLPs take no operational risk."

If natural gas prices increase substantially, coal MLPs surely will benefit. "We still produce 40% of our nation's power using coal," says Pusateri, "so even if natural gas prices stay low for the foreseeable future, coal isn't going away."

Analysts point to Alliance Resource Partners as another outstanding MLP focused on coal. "If you're going to buy any coal MLPs, you probably want to buy Alliance Resource Partners because [President and CEO] Joe Craft is a genius. If anybody can navigate coal fundamentals, he can," says Bellamy.

Infrastructure Plays

Midstream MLPs offer clients a conservative investment with enormous opportunity for growth, experts point out. "It's going to take another five to seven years just to build out the pipelines to transport the [hydrocarbons] form source to demand locations. That in itself is titanic," notes Weiss.

"MLPs are an industry of infrastructure. It's a huge fundamental story," he explains. "Five to seven more years of just building pipelines—and once things begin to pump, they pump for generations. Pipelines can be construed as cylindrical real estate. Right now, I can look at my hedge book and see that some of my plays already have 60% to 70% of next year's production hedged. Knowing the hedge book gives you a little heads-up on who is going to have the greater distributions."

What primarily drives MLP distribution growth is the capability of the partnership to re-invest capital, either in organic growth projects or by acquiring other, often smaller, companies. They may expand their existing infrastructure by adding capacity to a pipeline, by installing a new pipeline where one previously didn't exist or by reversing a pipeline. And, experts point out, an MLP's success is really in the hands of its management team.

That's why Bollinger spends a great deal of time with MLP managers, seeking to understand how they're deploying capital and what returns they're generating. "MLPs have a good opportunity set," he says, "so good management should be able to capitalize on that. We assess the management team and their track record. Not every team is going to be able to find the deals and execute on growth. And they may not be in the right [oil and gas] basins."

In choosing an MLP, Bollinger also studies coverage ratio: the amount of free cash flow an MLP is generating relative to the amount of cash it's distributing. "We look for companies that have excess coverage, companies that are being run relatively conservatively and have plenty of room to invest in projects that may come on at later dates or can tolerate some commodity sensitivity," he says. "We also look at the debt-capitalization ratio, which is how much debt these companies generally have as a function of their market cap. We don't want to invest in excessively levered companies."

Value in Variety

Diversification of the company itself is paramount, too, says Bollinger. "We look at how diversified they are across the value chain and across geography. For example, you don't want to buy [MLPs] only exposed to natural gas. You want crude oil, refined products and natural gas liquids, too. And you don't want only one geography, say, the Gulf Coast, which is subject to hurricanes. You want geographic diversity across basins: Utica exposure, Bakken exposure and so on. And you want both intrastate and interstate pipelines."

With oil, MLPs that connect North Dakota and Montana to refining hubs in Houston, for instance, are what Weiss prefers. "In the natural gas space," he says, "we're looking for plays that carry wet gas, which turns into all those petrochemicals … that end in 'ene.' "

Advisors also are looking forward to the liquefaction of natural gas for export. "This can create a whole new industry. [We'll be] sending it overseas, selling it to foreign countries. It's going to be a major trend to keep a close eye on," Blancato says.

As the world's leading producer of gas hydrocarbons, "The U.S. is the Saudi Arabia of natural gas," shares Flower. "So if you can find some MLPs that relate to that [development], they're a good investment."

Financial advisors who have made a place for MLPs in client portfolios can scarcely be more enthusiastic about this asset class. "Over the long term, we expect a solid average rate of return of between 6% and 10% during the next five years with a very low correlation to the general market. This is a great way to have a part of the energy revolution but not be directly impacted by fluctuations in the energy markets. We have an allocation to MLPs in every single one of our portfolios ranging from 3%-6%," Blancato says.

Plus, MLPs are indeed excellent long-term investments. "These companies have an incredible opportunity set over the next decade to continue to invest their own capital at good rates of return and increase their cash flow, and ultimately increase their distributions to unitholders, which is good for the long term, not just the short term. MLPs have a place in every portfolio," Bollinger stresses.

Energy MLPs are focused on vital, permanent infrastructure. "Unlike Dell PCs, [pipelines] won't become obsolete in our lifetime," Weiss says. "I'm sitting on what I think is the biggest growth rocket ship in the economy. So far with MLPs, I've not only increased clients' income, I've increased their sleeping level."

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